Company or trust, what’s best for you?

Do you want to know what is best for your business, a company or trust, as well as know what the differences are and why you should choose one over the other?

It’s hard to get a clear explanation about this without paying an accountant a lot of money and then, you still risk being confused. The wrong decision can leave you paying too much tax and high accounting fees whilst not protecting your assets.

We understand that corporate structures can be made over-complicated and we know you want to make the best decision for yourself, save tax and protect your assets, so here’s a quick guide about the key differences between how companies and trusts work.

For the sake of this article, trusts will refer to discretionary trusts. These trusts are often called family trusts, as they typically involve family members. They are called discretionary trusts because the controllers of the trust (trustees) have discretion as to who gets the income (the recipients of this income are known as beneficiaries).

Flexibility of Distribution of Profits

With a trust, there can be flexibility with the distributions of profits. For example, if profit is $100k, the trustees decide which family members get the $100k. There is, therefore, flexibility to distribute profits to family members on lower tax brackets and thus save tax. However, there are strict rules concerning personal services income, so if you are using a trust and providing your labour similarly to the role of an employee, you may be unable to distribute profits to family members and save tax.

Furthermore, the attractiveness of distributing profits to family members can be overrated, as many people are in two income families where the effective tax rates for each person are either the same or only have a small difference. This means that distributions to different family members don’t result in a tax saving or result in only a small saving.

With a company, it’s not as flexible in terms of distributing profits, as a company has to declare wages or dividends in order for shareholders and employees to receive funds. The dividends will typically be paid according to the share structure, so it’s not possible to simply decide that one person will get $x and another person will get $y. However, if you are a ‘husband and wife’ company and you aren’t providing ‘personal services income’, you can relatively easily work out an appropriate wage and dividend structure that will result in similar income for each person as in a trust.

Directors Loan Issues and Ease of Management

A trust is easier to manage in terms of personal drawings and wages and tax. The profits of the trust are typically distributed to individuals at the end of each year and this income is declared in the individual’s tax return and tax paid by the individual. This is the end of the matter (although there are proposed changes that are complex concerning funds showing as owed by the individual to the trust in the financial statements).

With a company, directors often draw more funds out of the company than what they declare as wages or dividends. This problem can not currently happen in a trust because the trust distributes all its profits. When this occurs in a company, the directors have to declare these funds as a loan and repay the funds to the company, typically over seven years with interest rates set by the ATO. The end result is usually declaring dividends in future years, on top of any wages that are declared. This can create large tax bills and cashflow problems.

Capital Gains Tax Concessions

An advantage of trusts is that in the event of the sale of a business, trusts will receive the full benefit of the small business capital gains tax (CGT) concessions whereas shareholders in a company may not.

The CGT concessions will flow from the trust to the individual beneficiaries, whereas part of the capital gain in a company may be ‘trapped’ in the company and result in more tax than if a trust was used. If the CGT concessions are important to you, call me to discuss or consult with your advisor as this area is complex and this is a very brief, general overview.

Tax on Retained Profits

Companies get a fixed tax rate so retained earnings can be taxed at a lower rate (27.5%) than an individual’s marginal tax rate and reinvested. If you want to retain profits in a trust, you may be hit with tax at a higher rate than the company tax rate, as the trust will distribute all profits to you at the individual marginal tax rate of 34.5% kicks in after you earn more than $37k.

An alternative is to distribute trust profits to a company so the company pays tax at 27.5%, however care must be taken to ensure the payment is actually made and that funds the company receives are properly dealt with. You can not simply take these funds straight out of the company, they must be declared as wages or dividends or loaned on proper terms back to the trust.

Business Partnerships

It is far easier to take on board investors or business partners with equity in your business through shares in a company than through a trust. Discretionary trusts don’t have fixed entitlements to income or capital proceeds, so getting investors or partners to invest for a fixed percentage of equity is not possible in a discretionary trust. If you wish to use trusts with business partners, you will need to consider more complex structures such as a hybrid trust or a partnership of trusts.

Asset Protection

As a general rule, your assets held in a trust may be considered safer than in a company when considering asset protection from third parties external to business operations. If you are sued, assets in a discretionary trust are held for the benefit of all beneficiaries and are harder to access, whereas you may lose your shareholding in a company and the associated assets. Again, this is a very broad overview of a complex area that needs to be examined further if asset protection is important to you.

Uncertain Future

The Federal Opposition have vowed to tax all trust distributions at 30%. Many trusts will elect to pay wages rather than distribute profits in order for beneficiaries to have an effective marginal tax rate of less than 30%, however for some trusts, the 30% tax will be an issue and result in more tax.

The Federal Opposition have also vowed to put the company tax rate back up to 30%, from the current rate of 27.5%

Next Steps

If you are considering whether a trust or company is right for you, your individual circumstances will need to be taken into account. You might want a trust to ensure that you can definitely access the full amount of the CGT concessions or you may want to ensure your business profits have a capped tax rate with a company so you can reinvest more. Whatever the case, do your research or contact me to discuss further, to ensure you are fully-informed of the pros and cons of each alternative and make the right choice for your circumstances.

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